Seven tips for investing an inheritance

Mull the tax consequences and the investment merits, and above all don't rush.

Christine Benz 8 September, 2017 | 5:00PM

"What should I do with the money I inherited from my mom?" my friend texted me. "The cheque has been sitting on my sideboard for two months."

Her paralysis is understandable. Many people who inherit assets are still processing the loss of their loved ones; investing the money may seem like the furthest thing from their minds, or an unpleasant reminder of the permanence of the loss. If the inheritance is particularly large, it may swamp the other assets in the investor's portfolio.

And while my friend's cash inheritance was straightforward, the logistics of inheriting other types of assets can be bewildering: Inherited RRSPs, in particular, come with a web of complicated rules. If you inherited actual securities, you'll have to figure out whether to keep them as part of your portfolio or trade them for something else. You'll also have to weigh any short-term spending wishes for the money against the wisdom of socking all or part of the money away for the future.

If you've recently inherited some money, or expect to in the future, here are some tips for handling your windfall wisely.

1. Go slowly.
Widows and widowers are often counseled to avoid any major financial or lifestyle decisions immediately upon the passing of loved ones. Grief can cloud thinking, prompting choices that might look different a few months or a year hence. That "go slow" advice can make sense for the children and siblings of deceased individuals, too. While using an inheritance to take the entire family to Ireland to scatter mom's ashes might seem like the right choice immediately after her death, further reflection might steer you toward a more practical use of your inherited funds like college or retirement savings, for example.

2. Assess the tax implications.
Before making any further decisions with an inheritance, ask the executor what type of vehicle the money resides in. Here are some of the key wrappers you might inherit, along with the rules governing each.

Taxable account: When a person dies in Canada, all their assets are deemed to have been sold, and the estate must pay any capital gains tax that may be owed as a result. This means that if you inherit assets that the deceased held in a taxable (i.e., non-registered) account, the adjusted cost base of the inherited assets is reset to whatever their value was on your loved one's date of death. It's as if you had purchased them on that date of death, and you are subsequently responsible for capital gains tax on any appreciation that occurs between the date of death and the time you sell.

RRSP: If you inherit RRSP assets, they will already have been deemed to be withdrawn from the plan, with the estate having paid any taxes owed. Exceptions are made if you are named as beneficiary of the plan and are the deceased's spouse, dependant child or grandchild under the age of 18, or dependant child or grandchild of any age who is physically or mentally disabled. In those cases, the assets are simply rolled into your own RRSP (or RRIF) on a tax-deferred basis, and thus become subject to the same rules that govern your own plan; any withdrawal from the plan would be taxed at your own marginal rate. That's why a better option, if you don't need the money right away, is to keep the assets inside of your RRSP, stretching out the tax benefits of the wrapper. The rules surrounding inherited RRSPs are complicated; the Canada Revenue Agency website provides useful information, but consulting a tax specialist may be a good idea.

Company retirement plan: As with RRSPs, the rules governing inherited company retirement plan assets depend on whether you're the spouse or specified family members of the deceased, and whether the plan is a defined-contribution or defined-benefit plan. In the case of a DC plan, if you are the spouse you'll have the option, if pension payments have not yet begun, to roll the assets into your own RRSP or cash them in. The former is usually the better option, in that you can consolidate the account with your own to simplify oversight, and defer taxes. If annuity payments are already being made from the DC plan, the spouse may receive survivor's payouts at a reduced amount, though the provisions vary according to the jurisdiction. Financially dependent children or grandchildren may also qualify for tax-free rollovers of DC assets, though non-dependents are eligible only for transfers to a term annuity. If your deceased spouse had a defined-benefit plan, you'll likely continue to receive a survivor's benefit, though the details may vary from one plan to another. Check with the plan sponsor to be sure.

3. Assess the nature of the asset.
The next step is to assess the type of asset you're inheriting and determine whether to keep it as part of your portfolio or sell it. If you inherit cash, you're obviously free to spend or invest that money however you see fit. If you've inherited securities -- for example, a stock or a basket of stocks or mutual funds -- you'll have to assess the investment merits of the securities alongside the tax consequences of selling. As noted above, the rules about inherited taxable assets are quite generous to the inheritor; the cost basis is set at the date of death, so any taxes due will depend on appreciation that occurred thereafter. Given that, the potential tax benefits of hanging on to securities rarely outweighs the disadvantage of hanging on to random securities that aren't a fit with your portfolio plan.

If you inherit tax-sheltered assets such as an RRSP or TFSA and you then roll over the assets to your own account, you're free to swap into whatever investments you see fit. As long as the money stays within a tax-sheltered wrapper, you won't owe taxes on the changes.

Be careful not to let sentimentality cloud your decision-making. Perhaps you know that your dad loved holding stock of his employer, for example. But the emotional benefit of hanging on may not be worth the loss of diversification you'd face by maintaining such a large position yourself. Remember that your loved one's main goal in leaving any financial assets to you was to improve your financial position -- and in turn your life. Sentimental considerations should be secondary.

4. Balance your mad-money desires against your long-term goals.
It's tempting to think of an inheritance as mad money, especially if you weren't expecting to receive it. You could sink the cash into a kitchen remodel, for example, or take the family on a dream vacation. And an inheritance can be a godsend if you have a true immediate financial need, like if your car is on its last few miles, for example. But before going overboard on short-term expenditures, take a closer look at your progress toward major longer-term financial goals, such as your own retirement or education funds for your kids. If you've run the numbers and determined that those accounts are wanting, you may be able to find a comfy middle ground. A $50,000 inheritance could be split: $15,000 for a reasonable used car, for example, and the remaining $35,000 into your retirement fund.

5. Find your best ROI.
If you've decided to invest at least a portion of your windfall, a worthwhile next step is to identify which use of funds promises the best your best return on investment, or ROI. By that I mean that you should look across your total choice set -- investment opportunities as well as any debts that you owe -- and deploy the money in a way that maximizes your return. If you have high-interest-rate credit card or student loan debt, the best return on your money is apt to be paying back the money. After all, you'd be hard-pressed to find a guaranteed return on an actual investment that exceeds the interest you're paying to service the debt. On the other hand, if you have a very long time horizon, plan to invest in equities, and can receive a tax break on your contribution, steering the money into a tax-sheltered account may be the way to go. (Just remember that you'll still be subject to the RRSP or TFSA contribution limits.)

6. Assess asset allocation when investing the money.
If you've decided to invest the money in some fashion, consider your time horizon for those assets, as well as the complexion of your current portfolio.

Use Morningstar's Portfolio tool to take stock of your portfolio's current allocation and compare it to a reasonable target for your time horizon. If your portfolio's asset allocation is off track, you may be able to use the inherited funds to bring it back into line. Right now, for example, many investors' portfolios are listing toward aggressive equity investments, especially growth stocks and funds.

And while you don't want to get into market-timing, it's also worth considering the market environment before investing the entire amount into the market. While stocks don't appear to be egregiously expensive today, nor are they particularly cheap. That calls for taking a deliberate approach to putting new money to work; dollar-cost average, especially if the sum you're investing represents a large percentage of your net worth and/or you don't have an ultra-long time horizon.

7. Get help if it's a large sum (to you).
Finally, if your inheritance represents a large sum -- to you, if not in absolute terms -- seek out professional advice about what to do with it. If your questions are largely tax-related, a CPA is likely your best resource; if you have questions about both investing and taxes, a financial planner should be able to address your concerns.

About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.